What is RBI rate normalization and how will this move impact you and me?

Initially it is being called normalization of rates and not increase in rates. However, on the face of it, interest rates will rise, for a reason the industry is calling it normalisation. The economy was hit by a recession during the pandemic that started in March 2020. To fight this, the whole country including the Reserve Bank of India took emergency steps. For RBI, the emergency steps were:

• Lower interest rates to a reasonable extent, so that money is available cheaper. Cheap money spreads faster, as people are driven to take out loans, which makes the wheels of the economy move too fast;

• Put a lot of cash in banks, to motivate banks to lend.

The effect of these measures has been limited, as demand for credit, which, as the economy was in recession, is now recovering and gaining steam. The context is that interest rates were reduced to emergency levels, which cannot be sustained for long. Now that the economy is returning to normal, rates will also have to normalize, which is why it is not being referred to as a rate hike.

For a perspective on how low the rates are, a “signal” is the repo rate, the rate at which the RBI will lend money to banks for a day if needed. The rate currently stands at 4%, the lowest ever. Then there is the reverse repo rate, the rate at which banks are flooding cash with the RBI, which currently stands at 3.35%. This is also the lowest ever, but for a brief phase in 2009.

To get a little technical, in the inter-bank call money market, the overnight rate, as it is referred to for one-day lending, is assumed to be within the repo-reverse repo band. Currently, due to infusion of liquidity by RBI, the overnight rate is at the lower end of the band, i.e. 3.35%. For a perspective on the extent of liquidity with banks, let us go back to the post-demonetisation period. Money flowed in banks, almost 15 trillion. Surplus money, which banks kept with RBI through reverse repo, was slightly higher than 5 trillion. In this phase of RBI’s pandemic support, the surplus money with banks is twice the post-demonetisation surplus.

What are the steps in the direction of the generalization we are discussing? The influx of liquidity with the banks will be gradually reduced so that the overnight rate gradually moves from the lower band (reverse repo) to the upper band (repo). With this, there will be no shortage of funds with the banks to lend. A reasonable surplus is enough, the flood is not serving any useful purpose. Then the reverse repo will be extended, probably on December 8 itself, to normalize the band (3.35% to 4%) while keeping the repo rate the same. The last step, which is to be raised in a calibrated manner, is increasing the “signal” repo rate. It is worth noting that even when RBI is going through the process or is being done, interest rates will continue to support the growth of the economy. From the low level of the emergency level only, it will be adjusted upward to the normal auxiliary levels.

What is the meaning for you and me? RBI has the responsibility of balancing the interest rates. On the one hand, it must be sufficiently low to support the growth of the economy, and on the other hand sufficient to be beneficial to the savers. Given the level of inflation over the past few years, real bank deposit rates are negative. Although inflation is now expected to moderate, deposit rates will have to be adjusted upward. So over time, things are expected to get a little better for savers, especially senior citizens, who have no active income. There will be room for moderation in lending rates; Banks are offering floating rate home loans this festive season with their margins at 6.5%, while the last repo rate cut by RBI was done in May 2020. As economic growth picks up, credit offtake is also expected to gather steam. Slightly higher rates than at present.

Joydeep Sen is a corporate trainer and author.